Corporate Issuers

Introduction to Corporate Governance & Other ESG

Considerations
Study Session 9
Reading No - 27
Learning Outcome Statements

The candidate should be able to:

a) Describe corporate governance;

b) Describe a company’s stakeholder groups and compare interests of stakeholder groups;

c) Describe principal-agent and other relationships in corporate governance and the conflicts that may arise in these relationships;

d) Describe stakeholder management;

e) Describe mechanisms to manage stakeholder relationships and mitigate associated risks;

f) Describe functions and responsibilities of a company’s board of directors and its committees;

g) Describe market and non0market factors that can affect stakeholder relationships and corporate governance;
h) Identify potential risks of poor corporate governance and stakeholder management and identify benefits from effective corporate
governance and stakeholder management;

i) Describe factors relevant to the analysis of corporate governance and stakeholder management;

j) Describe environmental and social considerations in investment analysis;

k) Describe how environmental, social, and governance factors may be used in investment analysis.
Los a:Describe corporate governance;

• The system of internal controls andprocedures by which companies ensure

transparency in working and

communicate effectively with all the stakeholders.

• It provides framework that defines the rights, roles and responsibilities of different
groups : -
• Management
• Board
• Controlling shareholders and
• Minority or non controlling shareholders.

• It minimizes and manages the conflicting interests between insiders and external
shareholders.
Los a:Describe corporate governance;
• The shareholders are not the managers – therefore, there is a conflict of interest between
• Owners and Management

• Directors, Creditors, Employees, Customers, and other stakeholders

• Corporate Governance is the overall construct within which a company is managed

Corporate Governance =Governance of a Corporate
• To ensure that the interest of the shareholders is not compromised, there are various things put in place to ensure
this.
• Etiquette

• Code ofConduct

• Discipline

• Checks & balances (Internal Control)

• Charter ofresponsibilities

• An effective and sustained channel of communication with the shareholders is at the core of corporate governance
 Los b Describe a company’s stakeholder groups and compare
interests of stakeholder groups;

• Board members act in the best interests of the shareholders.

• Company acts in a lawful and ethical manner in dealing with all
stakeholders.
• All shareholders have the same right to participate in the
governance of the company and their rights are clearly
delineated and communicated.
• Board acts independently from management and any other
entities.
• Appropriate controls and procedures are in place covering
management’s operations.
• Company’s operating , financial, and governance activities are
consistently reported to shareholders in a fair, accurate, timely,
reliable, relevant, complete and verifiable manner.
Los c:Describe principal-agent and other relationships in corporate
governance and the conflicts that may arise in these relationships;

Principal – Agent relationship is created when a Principal hires an Agent to perform a

particular task

or service. Principal-Agent relationship involves obligations, trust and loyalty. Shareholders

typically grant directors and managers the responsibility of managing the company, who in

turn work with employees to fulfil this responsibility.

Los c:Describe principal-agent and other relationships in corporate
governance and the conflicts that may arise in these relationships;

Controlling andminorityrelationship:

Straightvoting rights (one shareone vote) – minority shareholders can be outweighed;

Related partytransactions – have the potential to harm company’s profitability; and

Non-votingor limited voting rights – some companies may adopt a multiple class structure where different category of
shares have differential voting rights.
Managerand board relationships – Board relies on management to run the company. However, Board’s monitoring
role may be compromised due to lack of information as compared to the management.
Shareholder versuscreditor interests – Shareholders typically prefer high risk projects to take advantage of growth
opportunities whereas creditors and lenders will prefer that company takes low risk, stable projects so that their principal
and interest repayment is guaranteed.
Los c:Describe principal-agent and other relationships in corporate
governance and the conflicts that may arise in these relationships;

Other stakeholderconflicts – Shareholder vs Customer – Shareholder would prefer higher

prices

whereas customer would prefer lower prices.

Customers vs suppliers– Allowing lenient credit terms to customers may compromise

company’s ability to repay suppliers.

Shareholders vs Government– Shareholders would prefer a lower equity capital base and

lower taxes. Government and regulators would prefer the opposite.

Los d:Describe stakeholder management;
Mechanism:

• General meetings
• Board of director
• Audit Function
• Reporting and transparency – Shareholders need information to assess company performance and
reduce asymmetry of information between them and management.
• Policies on related-party-transactions should be adopted.
• Executive Remuneration policies should align shareholder and manager interest.
• The concept of say on pay enables shareholder to vote on executive
remuneration matters. Contractual agreement with creditors, Customers
and suppliers
• Laws and regulations
Los f :describe functions and responsibilities of a company’s board of
directors and its committees;
• These are the representatives of the owners which are appointed to ensure the proper corporate governance

• In one-tier BoD, only single line of BoD is present. In two tierBoD, a supervisory board comprises of non- executive directors and management
board comprises of executive directors.
• An independent director is a non-executive director who has no material relationship with company.
• The duty of the board is to act in the long term interest of the shareholders.
• Three characteristics of BoD:

• Independence;

• Experience and

• Resources.
Basic features of an effective BOD
1. A majority of the board should be independent of the management.
2. The board should meet regularlyoutside the presence of the management.
3. The CEO of the company shouldnot be the chairman of the board.
4. The board should notconsist of people who the company does business such as suppliers or customers.
5. Board members should also be qualified,haveadequateexperience, should regularly attend the meetings.
Los f :describe functions and responsibilities of a company’s
board of directors and its committees;
Frequency of Board Elections

Things to be considered

• Shareowners may elect board members:

a) Specified term – completeboardisre-elected, say after 3 years, OR

b) Staggered multiple-year terms – Board is dividedinto classes and each class goes for election in consecutive years.

• The board has filled a vacancyfor the remainder of a board member’s term without receiving shareowner approval at the next annual
general meeting.

• Shareowners canvote toremove a board member under certain circumstances.

Los f :describe functions and responsibilities of a company’s
board of directors and its committees;

• Audit Committee: To Ensure that financial information reported by the company to the shareholders is complete, accurate, reliable, relevant,
and timely.

• Governance Committee: This committee guarantees that the organization embraces good corporate governance practices.

• Remuneration Committee: The following are its functions:

• To ensure that compensation and other awards encourage executive management to act in ways that enhance the company’s long
term profitability and value;

• Include only independent board members on the committee and

• Linking executive compensation to the long-term profitability of the company.

• Nominations Committee: This committee distinguishes candidates who meet all the requirements to serve as directors, and suggests their
nomination for election by shareholders.
• Risk Committee: They oversee the establishment of enterprise risk management plans and then monitors their
implementation.
• Investment Committee: The function of this committee is to survey material investment opportunities proposed by the administration
and consider their suitability for the organization.
 los g:describe market and non-market factors that can affect
stakeholder relationships and corporate governance;

Market factors : -
• Shareholder engagement – Growing trend in companies to engage shareholders beyond just general meetings is known
as shareholder engagement.
• Shareholder activism – Strategies used by shareholders to compel a company to act in a particular manner, usually for increasing
company value is shareholder activism.
• Competition and takeovers – When the takeover of a company takes place, shareholders join together attempting to gather
enough shareholder proxy votes to win a corporate vote is called proxy takeover. In tender offer, shareholders directly sell
their shares to a group looking to gain control. Hostile takeover is one where the consent of company’s management is not
involved.
Non-market factors : -
• Legal environment - Common law system (legislature and Judiciary both make statutes) is superior for stakeholders as
compared to the Civil Law system (only Legislature makes statutes);

• The Media – can influence stakeholders due to its ability to quickly spread information
• The corporate governance industry – with increased importance of corporate governance, the demand for external corporate
governance services has grown considerably.
Los h: identify potential risks of poor corporate governance and
stakeholder management, and identify benefits from effective corporate
governance and stakeholder management;

Shortcomings in stakeholder management systems or the appropriation of poor

administration structures can make various risks for stakeholders and an organization. It
encompasses:

• Weak control system

• Ineffective decision-making
• Legal, regulatory, and reputational risks
• Default and bankruptcy risk
• A good governance structure can be reflected in operational efficiency, improved control
forms, better monetary execution, and lower levels of risk.
LOS i:describe factors relevant to the analysis of corporate
governance and stakeholder management
Some key questions that analysts may consider when assessing a Sources of potential risk
company’s corporate governance or stakeholder management • Economic and ownership control
system are as follows: • Board representation
• What is the company’s ownership and voting structure among • Remuneration and company
shareholders? Who represents shareholders on this company’s performance
board? • Investors in the company
• What are the main drivers of the management team’s • Strength of shareholders rights
remuneration and incentive structure? • Managing Long term risks
• Who are the significant investors in the company?
• How robust are the shareholder rights at the company, including
relative to peers?
• How effectively is the company managing long-term risks, such
as securing
• access to necessary resources, managing human capital,
exhibiting integrity and
• leadership, and strengthening the long-term sustainability of the
enterprise?
Los k:describe how environmental, social, and governance factors
may be used in investment analysis
• ESG integration is the act of considering ecological, social, and governance
elements in the investment procedure.

• Negative screening is the most common ESG investment strategy. It refers to

the practice of excluding certain sectors, such as companies engaged in fossil
fuel extraction or production or excluding companies that violate accepted
standards in such areas as human rights or environmental concerns.

• Positive screening intends to distinguish best-in-class organizations

that grasp strong ESG-related standards in their operations and
procedures.

• Thematic investing strategies commonly refers to investing a specific

sector or as per a specific theme. For example, alternative sources of
energy.

• Impact investing aims to create a specific environmental or social impact

beyond just financialperformance.
Summary

• Corporate governance can be defined as a system of controls and procedures by which

individual companies are managed.
• There are many systems of corporate governance, most reflecting the influences
• of either shareholder theory or stakeholder theory, or both. Current trends, however, point to
increasing convergence.
• A corporation’s governance system is influenced by several stakeholder groups, and the
interests of the groups often diverge or conflict.
• The primary stakeholder groups of a corporation consist of shareholders, creditors, managers
and employees, the board of directors, customers, suppliers, and government/regulators.
• A principal–agent relationship (or agency relationship) entails a principal hiring an agent to
perform a particular task or service. In a corporate structure, such relationships often lead to
conflicts among various stakeholders.
• Stakeholder management involves identifying, prioritizing, and understanding the interests of
stakeholder groups and on that basis managing the company’s relationships with stakeholders.
• The framework of corporate governance and stakeholder management reflects a legal,
contractual, organizational, and governmental infrastructure.
 Summary
• Mechanisms of stakeholder management may include general meetings, a board of directors, the audit function,
company reporting and transparency, related-party transactions, remuneration policies (including say on pay), and
other mechanisms to manage the company’s relationship with its creditors, employees, customers, suppliers, and
regulators.
• A board of directors is the central pillar of the governance structure, serves as the link between shareholders and
managers, and acts as the shareholders’ internal monitoring tool within the company.
• The structure and composition of a board of directors vary across countries and companies. The number of directors
may vary, and the board typically includes a mix of expertise levels, backgrounds, and competencies.
• Executive (internal) directors are employed by the company and are typically members of senior management. Non-
executive (external) directors have limited involvement in daily operations but serve an important oversight role.
• Two primary duties of a board of directors are duty of care and duty of loyalty.
• A company’s board of directors typically has several committees that are responsible for specific functions and report
to the board. Although the types of committees may vary across organization, the most common are the audit
• committee, governance committee, remuneration (compensation) committee, nomination committee, risk committee,
and investment committee.
• Stakeholder relationships and corporate governance are continually shaped and influenced by a variety of market and
non-market factors.
• Shareholder engagement by a company can provide benefits that include building support against short-termactivist
investors, countering negative recommendations from proxy advisory firms, and receiving greater support for
management’s position.
Summary

• From a corporation’s perspective, risks of poor governance include weak control systems; ineffective decision making;
and legal, regulatory, reputational, and default risk. Benefits include better operational efficiency, control, and
operating and financial performance, as well as lower default risk (or cost of debt).
• Key analyst considerations in corporate governance and stakeholder management include economic ownership and
voting control, board of directors representation, remuneration and company performance, investor composition,
strength of shareholders’ rights, and the management of long-term risks.
• ESG investment approaches range from value-based to values-based. There are six broad ESG investment approaches:
Negative screening, Positive screening, ESG integration, Thematic investing, Engagement/active ownership, and Impact
investing.
• Historically, environmental and social issues, such as climate change, air pollution, and societal impacts of a company’s
products and services, have been treated as negative externalities. However, increased stakeholder awareness and
• strengthening regulations are internalizing environmental and societal costs onto the company’s income statement by
responsible investors.